Have You Considered the Financial Risks of Investing Before Making Any Investment Decision? Before making any investment decision you need to figure out the type of investment you are planning long-term or short-term, you need to assess the risks of investing money in those assets, this will save you from making any wrong investment decisions and potential monetary losses.
Depending on your current financial situation and your age, you need to consider your risk profile. It will ease your investment journey. I already discuss how to determine your risk profile in a blog post on How to plan your Investment. Please These are not any investment suggestions what I am going to discuss are some common investment rules that you may already know.
Let me clear a few things, in general for any type of investment there is some risk associated with it. Even if you put your money in bank FD and somehow the bank goes bankrupt then what will happen to your money?
As of the Financial Year 2020-21, if a bank defaults or goes bankrupt then each depositor in the bank is insured (Federal Deposit Insurance Corporation (FDIC)) up to a maximum of up to $250,000 per depositor, per insured bank, for each account ownership category.
So always consider some degree of risk when investing money in any assets or even an FD account. You have to be aware of what are the risks of investment and plan accordingly. Most investments don’t have a guaranteed rate of return. This is because when you are investing, you are taking on a certain level of risk. Each type of investment will have different types of risk.
Types of investment risk?
For our learning purpose, we will categorize the various risks of investment and today we are going to discuss them in detail. The main risks of investing associated with any type of investment are as follows :-
- Market Risk or systematic Risk (Mainly for market link investment)
- Diversifiable Risk or Unsystematic Risk
- Liquidity Risk
- Capital Risk
- Inflation Risk
- Credit Risk
Market Risk or systematic Risk (Mainly for market link investment)
When investing in the stock market you simply take the market risk. You cannot avoid the risks of investing in the stock market because it is not in your control and affects a large number of assets. Any new law or any new regulatory pass by the government that causes losses to your investment falls under systematic risk. One way to ride through the market risk is to stay invested for a long period of time.
Pro Tip: It is always good to understand what are the risks of investing before diving into any investment.
Diversifiable Risk or Unsystematic Risk
Unsystematic risk affects very few or any particular assets. This risk can be reduced by diversifying your investment. Diversifying your investment can significantly reduce the chance of unsystematic risk. An American investor Warren Buffet once said “Never put all your eggs in one basket”. You need to understand the underlying asset of your financial instrument where you are going to invest.
For instance, take the example of Mutual Fund investment that already covers this type of risk itself. Any Mutual fund itself invests in various assets, such as bonds, cash, or other commodities like gold and other precious metals. Also, there are various types of Mutual Funds available in markets Like Equity types, bonds, and balanced funds. This gives you an opportunity to invest in various assets at the same time to reduce your risk exposure. This diversification allows investors to reduce the investing risk factor of one particular stock or sector.
Liquidity Risk
This is a situation when you are not able to sell and raise money from your investment when needed. Liquidity refers to a market condition where buyer and seller are available at any time and you can sell an asset easily.
If there is not enough liquidity in the market you cannot sell an asset at the desired moment in time. To avoid this kind of risk, one should check the fund size, and age of the fund before investing in a mutual fund. More details are provided in the latter part of this Mutual fund Investment Guide.
Capital Risk
Capital risk is the possibility of a loss of part or whole of investment capital. Capital risk can be a market risk where the price of an asset moves unfavorably.
Inflation Risk
This is referring to the risk that your investment and cash flow will considerably reduce in purchase purchasing power due to inflation. The best way to beat inflation is to invest in a financial instrument that gives you a higher return than inflation over a long period of time.
Normally in the case of Mutual fund investment, you can expect a very good return that beats inflation by a wide margin. Because mutual fund investment and return are directly related to the market.
Credit Risk
Credit risk mainly involves Bonds and debt instruments. Generally at the time of maturity of bonds the company or the institution will pay the promised principal and the interest that they owe. But sometimes the company did not perform well and was not able to pay as they promised.
Generally, government bonds hold the least amount of credit or default risk whereas bonds were taken out by companies that have higher credit risk but also offer a higher rate of interest. There is some credit rating organizations that can help you to find good rating instruments online.
There is also some other types of risk that can affect the valuation of your investment like Business risk, Currency Risk, Interest rate risk, Management risk, Regulatory or legislative risk, and Political/Country risk. The mutual fund already mitigates all these kinds of risks by diversifying your investment.
The best part of the Mutual Fund investment is the diversification of your invested amount. You invest a small amount in a particular Mutual Fund but your money is invested in many companies because of this the risk associated with your investment is reduced drastically.
It’s Really Important to Understand Investing Risk Factor
Before Investing You Must Understand Your Risk Tolerance. Overall, you must diversify your investments when possible to reduce your level of unsystematic risk. However, keep in mind that systematic risk is not in our control and is dependent upon the economy. You have to determine where you want to invest your hard-earned money and consider what appropriate asset allocation is good for you depending on your age, risk tolerance, and time horizon.
If you do that, you will be well on your way to creating a strong financial future. When you invest, you are exposed to a mix of these risks depending upon the type of your investment. Being aware of the risks associated with an investment and weighing the potential returns against the potential risk is important for making an investment decision.
